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How have various asset classes performed during previous wars

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How have various asset classes performed during previous wars

Introduction

This article was posted on Saturday, 17:40, UTC.

North Korea, the dictator ruled nation has been threatening the US and its allies with a possible missile attack, which may also have a nuclear warhead on it. The experts are divided on the actual capability of North Korea to undertake the attacks, however, its leader, Kim Jong-un leaves no opportunity to provoke the US and its allies.

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Key points

  1. Stocks perform better than average when the conflict starts
  2. Gold rallies before the start of the conflict
  3. Bonds have underperformed stocks during previous wars
  4. The US dollar has fallen on few occasions during a conflict
  5. The current war, if it starts, can severely impact electronic goods
  6. The US national debt is likely to balloon if US involves itself in South Korea’s reconstruction after the war ends

Though North Korea’s military prowess is nothing great to write home about, it can still cause extensive damage to millions of civilian lives and the economy of its neighbor South Korea, to some extent Japan and the US territory of Guam. However, in this article, we shall restrict ourselves to the impact of the war on various asset classes and the world economy. We shall use the historical evidence to arrive at our conclusion.

How does the US stock market perform during wars?

The US has fought several wars since 1960 as shown above. While a few ended quickly, others have been a long-drawn affair. Notwithstanding, Barron’s has outlined the effect of the following seven major hostilities on the Dow Jones Industrial Average since early 1980s.

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Serial No War Year
01 The US invasion of Grenada 1983
02 The US invasion of Panama 1989
03 The first Gulf War 1991
04 The US bombing of Kosovo 1999
05 The US War of Afghanistan 2001
06 The second Gulf War 2003
07 The US bombing of Libya 2011

Source: Barron’s

The markets hate uncertainty; a proof of this is the average 0.6% drop in the Dow a month prior to the start of the conflict.

However, once the conflict commenced, the Dow quickly turned direction, rising 4% in the first month. The rally did not stop there. Over the next three months, the Dow rose an average 6.7%, and the gains swelled to 7.2% after six months of the start of the conflict.

Therefore, if history repeats itself, a war between the US and North Korea – if it were to happen – will not start the next bear market.

How does gold perform during wars?

Gold is considered as a safe haven during times of uncertainty. Therefore, the yellow metal has rallied from about $1260/toz to about $1360/toz levels, as tensions escalated between North Korea and the US.

But, will gold continue its rally if the war starts?

Economists at Capital Economics have analyzed gold’s performance since 1985, during military conflicts, acts of terror and political tension.

They established that “over the past forty odd years, the price of gold has on average risen by 4.1% in the six months prior to a conflict turning into a full-blown war. However, it barely moved in the months following the event. This makes sense as gold thrives in periods of elevated uncertainty and the start of an armed conflict partly erases that.”

Performance of long-term bonds during wars

Though bonds are also considered as a safe haven investment, their performance has lagged their historical average during wars, according to a study by the CFA Institute. The possible reasons are an increase in inflation during war times and the second is the higher borrowing by the government to fund the war. Due to these two, bond prices fall. Therefore, selling out of stocks and buying bonds fearing a conflict might not prove to be a good strategy. The only aberration was during the gulf war when bonds beat stocks, albeit marginally.

How does the war affect the US dollar?

The evidence of the past three decades shows that the US dollar weakens during war, according to Kathy Lien, Managing Director of FX Strategy for BK Asset Management. The US dollar fell 5% when the Libyan war started and fell 9% during the first three months of the second gulf war. The dollar was weak even during the first gulf war.

However, this time, the situation is more complex and a lot of currency movements will depend on whether China actively involves itself in the war or remains neutral. The Australian dollar, the New Zealand dollar, and the Japanese Yen will see large moves if China supports North Korea directly during the war, else the movement in the currencies is likely to be comparatively subdued.

“As the tensions grow the dollar will suffer and the actual announcement of war could take USD/JPY to 105 but if it’s a swift victory the pair would also recover quickly,” said Kathy.

Though historical evidence gives us some idea about the possibilities, every new war is different because it involves different nations and affects different asset classes.

What sectors will be affected if a war with North Korea takes place?

Commodities

North Korea, in itself, can’t impact commodity prices. However, it is surrounded by nations that are major consumers of commodities. China is one of the major consumers of commodities, however, it is unlikely that the war will impact China’s consumption materially.

South Korea is a major importer of coal and exporter of steel. Both these commodities will be majorly impacted because South Korea will be severely affected if a war breaks out. Similarly, liquified natural gas prices will be affected, as Japan is its largest importer in the world.

The seaborne trade will also be severely affected because China, South Korea, and Japan receive about one-third of the global seaborne crude supplies. Similarly, 84% of the world’s iron ore and 47% of the metallurgical coal reaches the shores of these three nations through the seaborne route.

The agricultural commodities will also be affected because China is a major importer of rice and soybeans while Japan is of corn.

Economic costs of the war

War has both a direct and an indirect impact on the economy. South Korea is a hub for manufacturing liquid crystal displays, semiconductors, and cars. A war will impact these activities, leading to a shortage across the globe. The alternative suppliers can’t bridge the gap in such a short span of time.  Therefore, prices of various electronic products are likely to rise significantly, which will impact the developed economies, including the US.

“U.S. spending on electronic items, including smart phones, cameras, tablets and computers accounts for roughly 1 percent of the consumer price inflation basket. If a war in Korea caused prices of these items to double, it would add 1 percentage point to U.S. inflation,” a report by the research consultancy Capital Economics warned, reports CNBC.

If inflation rises sharply, the Central Banks will be forced to raise interest rates, jeopardizing the fledgling global economic recovery.

Additionally, if South Korea’s gross domestic product (GDP) falls by about 50% due to war, it will reduce the global GDP by 1 percentage point, according to the report.

Once the war ends, South Korea will need huge capital to rebuild its infrastructure. If the US involves itself and ends up spending the same amount as it did in Iraq and Afghanistan, then the federal debt will reach 105% of GDP, the economists at Capital Economics warned.

Conclusion

Though historical evidence suggests that the equity market returns are better than average during a war, the situation might be different this time because of the nations involved. Any jolt to the weak economic recovery across the globe will dent the confidence of the investors. Therefore, we don’t expect the stock markets to rise substantially during the war.

Gold’s performance is somewhat neutral and it can be used to protect the value of the portfolio. Therefore, selling some overvalued stocks and buying gold might be a good strategy if a war seems imminent.

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Rakesh Upadhyay

Rakesh Upadhyay

Rakesh Upadhyay is a Technical Analyst and Portfolio Consultant for The Summit Group. He has more than a decade of experience as a private trader. His philosophy is to use technical analysis for momentum trading and fundamental analysis for long-term positions. Rakesh likes to keep himself fit by lifting weights and considers himself to be a spiritual person.

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